Equity Portfolio Selection Models in Practice

DESSISLAVA A. PACHAMANOVA, PhD

Associate Professor of Operations Research, Babson College

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

Abstract: Quantitative equity portfolio selection often involves extending the classical mean-variance framework or more advanced tail-risk portfolio allocation frameworks to include different constraints that take specific investment guidelines and institutional features into account. Examples of such constraints are holding constraints that set limits on the total concentration of assets in an industry, sector, or country; turnover constraints that restrict the amount of trading; tracking error constraints that limit the difference between the performance of the portfolio and a benchmark; and risk factor constraints that limit the exposure of the portfolio to a risk factor such as the market. Portfolio allocation models can also account for transaction costs, taxes, and optimization of trades across multiple client accounts. An important practical issue in quantitative equity portfolio selection is how to mitigate the effect of model and estimation errors on the optimal allocation. Techniques that are used to address this issue include robust statistical techniques for parameter estimation, portfolio resampling, and robust optimization.

An integrated investment process generally involves the following activities:1

1. An investor’s objectives, preferences, and constraints ...

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